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He runs a brilliant blog. Too bad it's marred by unsubstantiated daily rants against Keynesianism... Let's make no mistake about this, the ZeroHedge blog run by Tyler Durden is brilliant. But it is marred by daily rants against Keynesianism. That wouldn't be so bad if these rants were actually substantiated by facts and arguments, but we couldn't really detect much, if any. That Keynesianism doesn't work seems to be assumed to be self-evident at ZeroHedge.

We even tried to engage Tyler into a discussion about the topic, but he didn't take the bait seriously. So we'll debate from here.

The rants against Keynesianism are so frequent, we don't really have to provide many examples. Just one will do, to give you an impression:

And so, as any remaining voices of reason realize they are dealing with a group of deranged Keynesians, soon there will be nobody left in the administration who dares to oppose the destructive course upon which this country has so resolutely embarked, which ends in one of two ways: debt repudiation, or war. [ZeroHedge]

This is, of course, a bit harder to do with Larry Summers or Paul Krugman.

Not working? Here a typical commentary (albeit not from ZeroHedge) for those holding this view:

I’ve insisted all along that the US should have allowed the primary bear forces to fully express themselves, as they inevitably will do anyway. But in its arrogance and ignorance, the administration decided that they could halt or sidestep a recession by printing us out of trouble. It’s been a terrible and expensive mistake.... What’s next? I think Washington will continue trying to spend us out of recession. This did not work in the past, and it’s not going to work now.[Richard Russel]

First off, whether a particular economic policy isn't working is extremely difficult to ascertain, all kinds of statistical heroics need to take place and multiple studies need to confirm as few of these ever become clear-cut. The problem with economics is that there are just too many variables, and many are interdependent.

Even if it's not working, it might very well be because the stimulus was badly designed. For instance, tax cuts (at least 1/3 of the stimulus package) could very well have been mostly saved. Pretty plausible with an over-leveraged household sector in the face of the economic mayhem that was going on. Many Keynesians also argue the stimulus wasn't large enough.

We haven't heard many claiming that the stimulus didn't work pretty well in China, were it was proportionally significantly larger.

A good place to start the assessment of whether the stimulus worked is:

To come up with a diagnosis of the situation

To compare similar situations and look at policy differences and outcomes

First, the diagnosis.

Proper diagnosis: balance sheet recessions Before slashing the remedies, it might be worthwhile to actually devote some time figuring out what went wrong with the economy. We won't really deal with the origins of the financial crisis, but one thing is not in dispute. Over-levering of households and financial institutions has played a major role.

The question is, of course, whether America is in a similar situation as Japan. Well, if not, things are eerily similar, and in some expects actually worse (Japan doesn't depend on foreign capital).

The main cause of a balance sheet recession is that the private sector has bought assets with borrowed money, and something (usually a tightening of monetary policy) triggers a fall in these asset prices. This easily leads to a vicious cycle with worsening private sector balance sheets and de-levering, forced selling of assets, further asset price falls, further saving to repair balance sheets, which transfers to the real economy in lower spending and to the banking system in falling credit demand and a worsening of bank balance sheets.

Sounds familiar?

It could get distinctly worse if, apart from falling asset prices by efforts to repair balance sheets, the resulting decrease in spending triggers the general price level to fall. That would actually increase the real value of the outstanding debt, a really serious risk best to be avoided.

Albeit not by monetary policy, as Koo has a further persuasive argument: monetary policy is ineffective under a balance sheet recession as credit demand falls, even at zero interest rates (see exhibit 19). Now doesn't that sound like Keynes "pulling on a string?" Monetary policy does have some use by injecting capital into the banks to avoid a credit crunch (exhibit 12-14) and weakening the external value of the currency (exhibit 20).

We have to add here that Tyler Durden from ZeroHedge doesn't seem to disagree with Koo's analysis (see here, here, and here), yet violently disagrees with the policy remedy offered by Koo, which seems to follow rationally from the analysis. Tyler offers only a single argument (apart from mocking):

Keynes' ideas may have been an operable theory when the world was not leveraged 100% debt/GDP (and 400% total debt including assorted off balance sheet items). Now, it is not. And everyone who blindly pushes for endless stimuli will find out that the end-play to Keynes' fatally flawed economic theory is sovereign default. [Tyler Durden]

This is odd indeed. Koo's analysis is that the private sector is over-leveraged, embarking on de-levering, which results in a fall in demand (as well as lower credit demand and asset price falls). Rather than being an obstacle, the private sector de-levering is actually the rationale for the public sector to step in to fill the spending void...

What would have happened without expansionary policies? Saying that Keynesian policies aren't working (even if that can be conclusively shown) is not enough. One has to show there were better (non-Keynesian) alternatives available. Of course, we can never tell what would have happened if countries wouldn't have embarked on Keynesian stimulus, but perhaps the 1930s is a good reminder as any.

There is a certain amount of superficial elegance in arguing that if the cause of most of the problems is over-borrowing, certainly we shouldn't borrow even more, right? The immediate riposte against this is that sovereigns are usually able to borrow at substantially lower cost compared to the private sector.

More importantly, Koo, like the Keynesians, argues that the only rescue can come from increased public spending (not tax cuts, these will just be used to repair balance sheets). Koo argues that:

“Had there been no fiscal stimulus,” surmises Koo, “the Japanese economy today would have contracted by 40-50%, if the U.S. experience during the 1930s is any guide.” [Japan Review]

He also shows that, contrary to many perceptions, the medicine has done a great deal in alleviating the problem in Japan as balance sheets have steadily improved (exhibit 8).

There are some differences, like in Japan the main borrowers were corporations, while in the US the over-leveraged parties where households (buying real estate) and banks ("de-risking" these and thereby over-levering). Firms are actually hoarding (a lot of) cash [see Pragmatic Capitalist]

However, the situation is similar enough, and the risks described (the debt-deflationary vicious cycles) scary enough to take anyone raging about "deranged Keynesians" without providing any alternative (or even showing where the Keynesians are wrong) with a considerable amount of salt.

If anything, the initial stages of our own recent crisis were more severe than the Great Depression. Global trade, industrial production and stocks all dropped more in 2008-9 than in 1929-30, as a study by Barry Eichengreen and Kevin H. O’Rourke found.[New York Times 22]

Now, what might have stopped the rot last year? Isn't the rather swift policy reaction one of the main, if not the main difference from the 1930s? Doesn't that at least strongly suggest that Keynesian policies have prevented us from falling into the abyss that was the 1930s depression?

Isn't it therefore wholly premature, to say the least, for those arguing that it hasn't worked? But there is more.

The 1930s vicious cycle only started to break when policies were turned around, and although tight fiscal policy was by no means the only policy mistake early on (Ben Bernanke famously blamed the Fed for the depression, and adherence to the gold standard and rampant protectionism were other big mistakes), people who have looked at the data have concluded that:

Expansionary austerity? The alternative, supposedly is fiscal retrenchment, to avoid "leading us to debt repudiation or war," according to the alarmist ZeroHedge article quoted above. The crucial issue is, of course, whether the private sector will take up the slack. If Koo is right and the private sector is too busy repairing balance sheets, this is extremely unlikely. In fact, all that public spending is there exactly because the private sector retrenches.

We couldn't find a discussion on any of these issues on ZeroHedge, but even they can't deny the following logic:

"A reduction in the fiscal deficit must be offset by shifts in the private and foreign balances. If fiscal contraction is to be expansionary, net exports must increase and private spending must rise, or private savings [must] fall.[Martin Wolf in the FT]

This indeed is the central issue. How likely is it that the private sector will increase spending in the face of fiscal contraction (provided there is little chance foreign demand won't take up the slack as supposedly everybody should be waned off the Keynesian delusions).

Some, like Goldman Sachs have come up with studies containing examples where fiscal contraction turned out to be expansionary. However, as Martin Wolf pointed out:

Thus, experience of fiscal contraction is going to be very different when it occurs in a few small countries... when the financial sector is in good health... when the private sector is unindebted... when interest rates are high... when external demand is buoyant... and when real exchange rates depreciate sharply...." [Martin Wolf in the FT]

Here's Krugman tearing these to shreds:

So every one of these stories says that you can have fiscal contraction without depressing the economy IF the depressing effects are offset by huge moves into trade surplus and/or sharp declines in interest rates. Since the world as a whole can’t move into surplus, and since major economies already have very low interest rates, none of this is relevant to our current situation."] [Krugman]

The effectiveness of public spending There are, of course, perfectly reasonable economic arguments against public spending as a way to increase economic activity. They fall into three categories, although they all have in common that increase in public spending will somehow be offset by a decrease in private spending:

Crowding out

Ricardian equivalence

Say's Law

Crowding out It comes in different version, the most basic one argues that resources used in public spending cannot be used in private spending, or drives up prices of resources and thereby reduces private spending. This makes little sense when there are ample resources lying idle.

The main crowding out mechanism argues that bond-financed public spending claims a greater part of the savings pool, pushing up real interest rates and thereby reducing private spending. Have we seen interest rates increasing?

Not quite.

In an age of free-flowing capital, this argument makes less sense, as savings can come from overseas. One could still argue that tapping overseas savings to finance public spending could rise the real exchange rate, and thereby 'crowd-out' private spending via the trade balance.

But have we seen an enormous rise in the dollar as a result of stimulus spending?

The US did, by the way, have large trade deficits even in the final years of the Clinton administration when the Federal budget was actually in surplus.

Crowding out arguments make (some) sense in times when the economy is purring close to full capacity and resources are constrained, but not in a depressed world with idle resources. That hasn't stopped the austerity people invoking other arguments though.

Ricardian equivalence This curious theorem comes from the wet dream of conservative economist creating a parallel universe in which all markets clear instantly and all people are completely rational agents so their savings match expected tax increases as a result of stimulus spending dollar for dollar.

Do you know anyone who started to save more because of the stimulus spending? Has the idea ever even occurred to you?

Yet a surprising amount of politicians seem to ascribe to some form of this theorem, says Merkel:

Reducing the budget deficit by 10 billion euros ($12 billion) per year “won’t put a brake on the world’s economic growth,” Merkel said, relating what she told Obama yesterday. Germans are more likely to spend money if they feel the government “is taking precautions” to ensure solid finances, she said. [3]

The 'confidence' argument used here is just Ricardian equivalence in reverse.

We think Krugman has done enough to show that even if this curious theorem actually holds true, a temporary stimulus will still be a net stimulus:

It’s one thing to have an argument about whether consumers are perfectly rational and have perfect access to the capital markets; it’s another to have the big advocates of all that perfection not understand the implications of their own model. [Krugman]

Say's Law There are even those that argue that:

debt-financed government spending necessarily crowds out an equal amount of private spending, even if the economy is depressed — and they claim this not as an empirical result, not as the prediction of some model, but as the ineluctable implication of an accounting identity. [Krugman]

You should read the rest of the article to appreciate the nonsense of that. The proponents mistake an identity for a behavioural relationship. Actual savings plus tax receipts indeed equal actual investment plus public spending, but that's an identity. It says nothing about the behavioural relationship between the these variables.

So an increase in public spending could very well increase GDP, thereby increasing savings and tax receipts (so the identity holds), rather than necessarily reducing investment.

Simple budgetary arithmetic It turns out the stimulus is not terribly important in the greater scheme of public finances:

Consider the long-run budget implications for the United States of spending $1 trillion on stimulus at a time when the economy is suffering from severe unemployment. That sounds like a lot of money. But the US Treasury can currently issue long-term inflation-protected securities at an interest rate of 1.75%. So the long-term cost of servicing an extra trillion dollars of borrowing is $17.5 billion, or around 0.13 percent of GDP. And bear in mind that additional stimulus would lead to at least a somewhat stronger economy, and hence higher revenues. Almost surely, the true budget cost of $1 trillion in stimulus would be less than one-tenth of one percent of GDP. [Krugman]

IMF assesses that from a total of 35.5% increase of public debt as a % of GDP in the years 2007-14, only 3.5% comes from stimulus. [Krugman]

The risk of deflation

Let’s recap. Unemployment is high and is in reality going higher if you count those who would take a job if they could get one. Incomes are weak. Plans to purchase discretionary items are falling. Housing is likely in for a further drop in prices. The stock market is not exactly booming. Treasury yields are falling, not from a credit crisis or a flight to quality, but because of economic conditions (deflation). Money supply is flat or falling. Prices are under pressure. The list goes on, and all factors are indicative of deflation. [John Mauldin on Pragmatic Capitalist]

To embark on universal, hence synchronized fiscal austerity in this environment bears a considerable risk of plunging the world (at least the Western world) into a deflationary-debt spiral from which it's really hard to escape. Public finances will not improve, but that will only be 'collateral damage' compared to the carnage done to the real economy if this happens.

The limits of Keynesianism Yes, there are limits. It doesn't mean the theory is defunct. Some of the PIIGS are facing these limits (in the way of meeting actual, rather than imaginary bond vigilantes), but this is mostly produced because:

They can't depreciate their currency (compare the UK, which is the master of it's own monetary and exchange rate policy, with Spain, having comparable public finance problems but trapped inside the euro)

They've lost a great deal of competitiveness vis-à-vis the core euro countries, so even if they could inflate their way out of the public finance mess, that would aggravate the real economy.

We don't think there's any Keynesian who would argue that, say, Greece would have to embark on massive stimulus spending. The point about Keynesianism is that there is another part of the equation, countries have to run surpluses during the good times in order to be able to afford to embark on. That many didn't do that can't be held against the Keynesian theory and places greater responsibility not only on them, but also on the countries that did.

It might also be useful to keep in mind that many countries, including the UK and the US, had worse public debt situations after WOII. What happened is that a combination of economic growth and moderate inflation steadily reduced the real value of that debt as a percentage of GDP.

The positive case for public spending We wouldn't be surprised if many of the 'austerity now' advocates are also of the persuasion that government is always the problem, never the solution. These people might actually be reminded of the positive contributions to economic growth that public investments could bring (and have brought in the past).

We could cite lower transaction cost, valuable infrastructure, addressing all kinds of market failures like collective action problems, external effects, or information asymmetries (a prime cause of the financial crisis, as we wrote before). We could cite the GI bill, the education system that the US build a century ago which was an important factor propelling its economy higher, the things coming out of DAPRA, etc. etc.

One could argue that just like Japanese firms have the habit of increasing maintenance and training during slack times, public investment should be increased during slack times, not only to make up for the spending shortfall, but to upgrade the economic structure and thereby laying the foundations for future economic growth.

The Chinese are doing it. (Here is only one example, the amount of funds going into laying the foundation for knowledge-intensive industries is quite impressive.)

And as long as the returns from these kind of public investments are larger than the interest rates on the debt used to finance these (and for education and R&D spending there are numerous indications this is the case), we will actually improve public finances over time.

Austerity experiments Last, but certainly not least, one should have a look at the countries that did actually embark on austerity, like Ireland, Estonia, Latvia. These are small open economies, so their examples are best case scenarios as their austerity was at least partly offset by increasing economic conditions elsewhere. In fact, Leo Kolivakis just wrote this on ZeroHedge:

Krugman is right about Ireland, Latvia and Estonia. They all implemented savage cuts, unemployment went up, as did the cost of insuring their debt, and government revenues dwindled. It has been nothing short of a monumental disaster.

Now wait until most of the developed world will embark on austerity, instead of just a few small open countries free riding on the stimulus of others. The result will be much worse. Which is perhaps why:

There is little evidence embarking on austerity, instead of Keynesian demand management as a reaction to a private balance sheet recession provides better economic outcomes.

If the 1930s or Japan 1990-2010 are any guides, the evidence points squarely in the other direction.

The few austerity cases today are best-case scenario's for the austerity camp (as they're open economies and essentially free-riding on the stimulus of others) don't provide much hope either.

The austerity camp seems to be blind to the debt-deflationary vicious cycle risk of a universal austerity policy in the Western world.

The numbers actually show that the discrete Keynesian spending is a small part of the public finance problem.

The austerity camp also seems to be blind that public investment, apart from making up from decreased private spending, could generate positive longer-term returns for the economy and thereby public finances if the return on the public investment is larger than the interest paid on the debt issued in order to finance it. Considering the low interest rates and public investment categories like R&D and education which are generally recognized to have significant returns, this seems quite plausible.

The theoretical underpinnings of the anti-Keynesian camp is pretty shaky to say the least. They have certainly not shown how public spending crowds out private spending in situations of underused resources, or that people will offset public spending to save for future tax increases, or that Say's law holds.

The examples of cases where austerity turned out to be expansionary depend on the private sector and/or overseas spending to compensate reduced public spending. Most of these cases involved either sharply lower interest rates and/or increased competitiveness. Interest rates are already very low and there are few currencies against which to devalue left if the whole Western world embarks on austerity, so these examples are not likely to be very relevant.

That quote comes directly from Howard Sirota. InterOil hasn't "repelled" Boone nor Merrill. Both went almost bust. Merrill's wings were cut after BoA takeover. And we all know what Howie hasn't delivered..

["InterOil has leaked or floated the name of every major Asian energy giant as a bidder, but to date there are no bids whatsoever."]

They cannot know this for a fact. Period. Again shows the level of integrity of their "analysis". There are plenty of press stories confirming interest in InterOil (see here, here, herehere, here, here, and here

4) ["Critics include two ex-cons-turned-fraud investigators Sam Antar of White Collar Fraud and Barry Minkow of the Fraud Discovery Institute (which funds iBusiness Reporting), and the ValueHuntr who recently recommended shorting the stock on the Motley Fool investment website. Minkow, who also holds a short position with InterOil, accused the company in a December press release of being “nothing more than hype.”]

5) [In the recording, Andrews also predicted a market cap for InterOil in coming years in the $10 billion range [it was $1.3 billion at the time], and told the undercover investigator that the company had 3 trillion cubic feet of certified gas resources, though company states in public documents that it has no proven finds.]

Of course it has no proven finds! It doesn't have production facilities so by definition it hasn't proven finds. What they do have is two independent resource evaluations. One by GLJ, which argues InterOil has 3.43Tcf of recoverable gas (P2) and one by Knowledge Reservoir which argues InterOil has 6.7Tcf of recoverable gas (P2).

To put that into perspective, one has to realize that the GLJ report was brought out before it could include any meaningful data from Antelope1 (and none from Antelope2), and that Antelope1 compared to the Elk wells has:

15-25x the net payzones of the Elk1&4 wells

with 8.8% average porosity considerably higher and dolomite and reef rock being of much better quality

The question is, would including the data from Antelope1 lead to an increase in the resource estimate? We already know the answer, because that is exactly what Knowledge Reservoir did and it came out with an estimate of 6.7Tcf of recoverable gas (P2).

But even the Knowledge Reservoir report doesn't include anything from Antelope2, which:

Proved out the Antelope structure 2.2 miles south of Antelope1

Proved the formation being 100 meters higher than previously estimated by seismics

Has a substantially higher average porosity compared to Antelope1 (14% versus 8.8%), resulting in doubling the gas flow to improve the previous world record set at Antelope1

Now, the question is, would including these data from Antelope2 result in a higher resource estimate? Asking that question is answering it, but if you still doubt that just wait until these reserve reports are updated in March.

6) ["On June 26, 2006, InterOil announced a gas and gas liquids discovery at a test well called Elk 1 and its stock jumped as high as 25% that day. But to date, Elk 1 has produced no gas resources."]

This is even laughable. "But to date, Elk 1 has produced no gas resources"... No, of course not. They have no pipeline or LNG plant. But that doesn't mean the gas isn't there...

7) What is actually misleading about these PR's?

Perhaps that's the reason the article acutally doesn't dare to say specifically where they are misleading. The one time the do that, the result is laughable (see point 6 above).

On Januari 11, the shares of InterOil, an exploration company operating on Papua New Guinea tumbled more than 10% on heavy volume, only to recover a good part of these losses later in the day after a couple of analyst (Morgan Stanley, Nataxis Bleichroeder, Raymond James) explained that the market had interpreted the DST results badly. Is there still value in these shares? We believe so. What was wrong? The market zoomed in on the 11MMcf/d flow rate, which compared bleakly to the 705MMcf/d world record earlier from the same well. However:- Gasflows were not the objective of this DST, the objective was the condensate/gas ratio, which came in at 20.7bbls/MMcf, which is 25% (not 15%, as the PR has it) higher than at the top of the payzone (16.5bbls/MMcf)- The choke used in the DST was really minute (48/64 inch) compared to the 6 inch one used in the record setting flow test.- The high porosity dolomized reef which produced the big gasflow was sealed off, the tested area has lower porosity.

Let us re-introduce the company and it's main asset (we've written extensively about it before):- It has a large gas and liquids field Elk/Antelope with the top two producing gasfields (at 382MMcf/d and 705 Mmcf/d, with 5000 bbls and 11,200 bbls/d condensate rates) in the world, Antelope1&2- It has more than 40 other promising drilling sites on over 4M acres- It has a 36,500 bbs/d capacity refinery operating at slightly over half capacity but still producing small profits- It has a fuel distribution network on PNG that is a near monopoly that is profitable.

Changed companyLast year, the shares have been on a tear, rising over 500%. There are many reasons for that:- The Antelope resource turned out to be quite another beast compared to the earlier Elk wells, with net payzones 15-25 times larger, porosity higher and rock quality much better (a reef with large parts of dolomization).- They had their first official resource estimation from GLJ (3.43Tcf P2, although we have to stress that this basically excludes all data from the Antelope wells, so the real number will be several times that (expect an update in March this year)- A second report from Knowledge Reservoir included the info from the first Antelope well and arrived at 6.7Tcf (P2). George Soros took a large position at just under $35 and kept adding to that (he holds 2.8M shares)- New analyst coverage with Morgan Stanly increasing it's price target in steps from $65 to $115 a share recently and Nataxis Bleichroeder having an $98 target. - After an initial scare in the summer, the PNG government approved the LNG plant proposal, which is budgeted at only half the cost compared to the Exxon/OilSearch one (the difference is due to infrastructure already in place, cheaper and more productive wells, InterOil being much closer to the LNG plant site and having a single resource in the lowlands, compared to scattered resources in the highlands for the other LNG project)- Prime Minister Somare announced a MOU between InterOil and Mitsui about a liquids stripping plant which will give InterOil a significant early monetization opportunity. The final agreement is pending the ongoing testing at Antelope2.

Future catalystThe rise last year was quite spectacular. Does this mean that there won't be reasons for the stock to continue to go up? Well, not necessarily:- any increase in the condensate/gas ratio at the (near) bottom of the Antelope2 well will have a significant impact on the economics of the stripping plant (see below)- The signing of the liquids stripping plant deal (there is an MUO with Mitsui from Japan) is awaiting the well news- At Antelope1 there was an oil leg below the gas but it was in tight rock. The chances of getting it out at Antelope2 are much better, as the reef dips down. Horizontal drilling will further increase the chances for a commercial oil leg.- In February or March, there will be a resource upgrade year end report. Including the very prolific Antelope1&2 wells will increase estimations several fold- Antelope 3 (between Antelope 1&2) will arrive in the second quarter- After work at Antelope2 is finished, InterOil will continue to pursue a couple of deals: an upstream sell-down and an LNG partnership. These will give them funds to pay their part of the LNG plant and accelerate their exploration efforts applying multiple rigs.- We can expect the first of the unexplored structures to be drilled in the second half of this year.

Morgan Stanley just increased it's price target to $115 on the following assumptions:1) Resources: 6.7Tcf of gas and 120MMbbls of condensate, although there is upside including Antelope2 data as the 6.7Tcf is Knowledge Reservoir's assessment before Antelope2 was drilled. Antelope2:- was found 345 feet higher, increasing the reservoir rock significantly- proves Antelope to the south- has 14% average porosity over an 1100ft net payzone

2) Sale price of $1.63 per Mcf for the upstream sell-down of a part of Elk/Antelope (35% max) of 6.7Tcf (there is upside to that, as this is the Knowledge Reservoir figure excluding Antelope2). This $1.63 is still below comparable transactions like Nippon paying $800M ($2.16 per Mcf) for a small stake in the Exxon/OilSearch fields.

Liquids strippingThe liquids stripping plant is well supported by the new DST results, which came in 25% (not 15% as MS has it) above the figures from the DST at the top of the payzone (DST1). It's perhaps best to quote the MS report at length for better understanding:

The impact of a higher condensate ratio reported today is twofold: - (1) it increases the amount of condensate in the structure (have to wait for GLJ estimate to get the amount), and - (2) could increase the producible rate in the condensate stripping facility.

The planned facility cost is $450MM for a 1 train stripping facility (approximately $220MM for facility, $100MM pipelines, and $120MM for drilling capex). The train is designed to strip condensate associated with 400mmcf/d of natural gas flow, so improvement in the condensate ratio, will also improve facility flow rate, cash flows, and the associated NPV.

We assume 22.4 bbls per 1mmcfe to yield 9mmbpd from the facility and the condensate ratio from today’s test at an adjusted 26 bbls per 1mmcfd represents potential upside to 10–11 mbpd. Each incremental 1 mbpd of processed condensate improves the NAV by approximately $1.50 per share (pre-sell down) on the same resource amount. Additional trains could be added at a cost of $220MM per train, so economics improve for each additional condensate train added.

On the MOU between IOC and Mistui, Morgan argued:

The agreement will likely also provide an off-take agreement for naphtha, a product of the condensate refined at IOC’s refinery. We believe the MOU is an important first step and a binding agreement will be executed in 1Q10. The key terms to be negotiated are likely the off-take agreement and whether and how the facility could be converted into an upstream interest when the LNG sell-down closes. We believe signing a liquid stripping facility financing and off-take agreement would have the following positive value implications: (a) it would de-risk the liquid stripping value; (b) it would support our increased price assumption on the upstream sell-down as the more immediate cash flow stream and liquids drive higher value in the sale, (c) it would mitigate 2010 funding issues as the credit facility could fund associated Antelope drilling which preserves IOC’s $80MM cash for other exploration (effectively improving IOC’s leverage in its sell-down process), and (d) it will improve the refinery profitability by increasing throughput by 9–12mmbpd without any additional working capital requirements (condensate production rate).

Oil?Antelope1 showed oil, albeit in tight rock. The chances of getting the oil out at Antelope2 are higher, especially with the help of horizontal drilling (see here for a good explanation by a petroleum engineer). Antelope is roughly 12x4 miles, which yields 30,000 acres. Morgan assumes 20% of the acreage can produce oil and a 15-20% recovery factor, 5% average porosity and 80% saturation, which yield a possible 85-115MMbbls of recoverable oil. This would add $42 to their base ($115) share price target which doesn't include anything for the oil. An oil recovery would also:- de-risk the LNG/sell-off of a stake in Elk/Antelope- force the street to assign some value for IOC's exploration portfolio (over 4M acres).

Criticism?Once, InterOil had over 11M shares short and up to 6M undelivered shares. It spend years on the RegSHO list. This is largely in the past, However, there is a small but voiceforous band of critics led by Barry Minkow's "Fraud Discovery Institute". They haven't had the best of years, being short since the mid 20s. Morgan Stanley argued in their first report that it was "not meaningful" and we have previously busted their arguments (for a summary, see here, especially the rebuttal of what they caracterized as the prime risk, pressure depletion in the wells)

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